Warren Buffett is undoubtedly one of the most successful investors in the stock market; his methods are very simple yet effective. Most investors who invest in the stock market lose money because they don’t fully appreciate or understand the company that they invest in, some invest by looking at charts while others invest purely on recommendations and rumor.

A better way to invest is to look at the underlying fundamentals of a company to see if it really is worth buying. Warren Buffett is a value investor who looks at the companies financials before be even considers buying stocks.

How Warren Buffett Chooses Companies

Warren Buffett only buys companies that have a durable competitive advantage; this means that the company has a strong brand presence; it does not have to compete on price and it has a durable brand that does not need big investments to maintain its number one position.

Some of companies that have durable competitive advantages include Coca Cola (KO), Johnson & Johnson (JNJ), and H&R Block (HNR). The most important point that value investors look at is the financial strength of the underlying stock, once they’ve picked several companies that fit the criteria they wait for when the stock market plunges to buy positions in the company.

What Financial History Does Warren Buffett Look At?
There are ten key financial data that Warren Buffett looks to identify a durable competitive advantage. If a company possesses all these traits then it’s more than likely that the stock has a competitive durable advantage and will continue to make shareholders money in the future.

P/E Ratio: The price earnings ratio takes the price of the stock and then divides it by the earnings per share of the stock. What you are essentially looking for is low PE Ratios which would mean that the stock is relatively cheap for its price. Another way to think about PE Ratio is how much money you have to invest to get a dollar back in return.

Some companies have PE Ratios of more than 60 which means that you’ll have to spend $60 to see a return of $1. When a stock market is about to burst its bubble PE Ratios go to historical highs some even reaching 100, this is the best time to sell positions and then wait for the crash or bear market which will revalue to company at a lower price upon which time you can buy the stock cheaper, it’s like buying a dollar for 50 cents.

Return of Equity and Return on Capital: Warren Buffett also looks for high Return on Equity and Return on Capital, if companies show a high return on both key indicators it shows that the stock is in a very strong position. If a company has assets of $100 billion and liabilities of $50 billion and has made a profit of $3 billion then the return on equity is $3b/($100b - $50b) which is 6%.

The return on capital is calculated as $3b/$100b which is 3%. What you are looking for is companies which have a return of more that 12% for ROE and ROC. The reason Warren Buffett uses 12% is because this is the average rate of return the stock market has produced and he only picks companies that have a higher return than the average.

Long Term Debt: Value investors also look at long term debt and the ability to finance that debt, if a company has $300 billion in long term debt and has average retained profits of $60 billion per year then it will take just over 5 years to wipe the debt clean, what Warren Buffett Looks for is companies that have little or no debt and the ability to pay off that debt quickly.

Share Buy Back Programs: Another key indicator that many people overlook is to check whether the company has an active stock buy-back program, having an active buy-back program makes shareholders richer.

If for example there are three partners in a company they have to split the profits three ways, if two of the partners buy out one of the partners the profit will be divided two ways making the shareholders or partners richer.

You can check whether a company has an active buy-back program by looking at how much outstanding shares there are on the market, you are looking for a steady decline.

Labour Disputes: Some of the stocks that Warren Buffet likes to avoid are those where the workforce have considerable power to really throw a spanner in the works of a company’s profits. If airline pilots decide to go on strike this will really dent the profits of a company, if intellectual property decides to leave your company and join another then you’ll lose revenue to your competitors.

Buffett likes to invest in companies where the workforce can’t disrupt the long term profits of a company, where the staff can be easily replaced if they wield too much power. Companies where the labour force has destructive power includes airlines, car makers and investment banking.

Keeping Abreast of Inflation: Inflation eats into profits, if you buy stock in a company where they are constantly having price wars you as a shareholder won’t get any richer.

Take the airline stocks as an example, the price of airline tickets in the last 10 years has decreased significantly while the cost of raw materials, labour and capital have increases significantly, this means that long term shareholders are either getting poorer when taking inflation into account.

By investing in a company which has a durable competitive advantage they can raise the price of their product when the cost of production rises therefore keeping ahead of inflation making shareholders richer.

When to Buy Value Oriented StocksIf you can pick a portfolio using these key metrics then you’ll be able to find stocks that are fundamentally strong and can recover from almost any calamity or stock market crash.

The best times to buy these stocks would be when the market has crashed and the short sited stock market undervalues these stocks, or when a strong company experiences a calamity and the stock market punishes them by severely undervaluing the company, this calamity should be one the stock can recover from.

Stocks in Warren Buffett’s PortfolioHere is a list of Warren Buffett’s favourite stocks which has made him billions, if you can get your timings right you’ll be able to profit from these stocks every time the stock market undervalues them. I have also linked these stocks to the 10 year financial history on MSN money central which will really help you to see the company’s financial health.

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